Thursday, March 5, 2009

Pensions' Alternatives Albatross?

Investors wrestled with relentless uncertainty about the financial system and fresh concerns about GM. Short selling -- bets that stocks will fall -- ahead of the government's Friday employment report exacerbated the losses, slashing 281 points from the Dow Jones industrials and sending all the major indexes down more than 4 percent.

Stocks fell in every industry, with beleaguered banks posting some of the steepest drops. Citigroup Inc., still shaky despite receiving billions in government aid, at times sank below $1 and finished down 9.7 percent at $1.02. GM, meanwhile, ended with a loss of 15 percent at $1.86 as it warned of possible bankruptcy.

"Citigroup going below a buck today was a little scary," said Mark LeStrange, director of sales at Source Trading.

"To say that we're cheap here and it's a good value, it sounds right, but in all reality we could go 50 percent lower," he said. "Nobody has any idea how low we can go."

If you believe the earnings estimates put forth by S/P then the multiples are starting to look interesting at around 15x earnings.

That's the question. Are those estimates valid ? Who knows? That's what's making investors so skittish. Nobody knows anything about valuations. All former thoughts and ideas are out the window.

We're now in a new world. Who knows what banks will earn. Without that knowledge, it's impossible to predict s/p 500 earnings. You need that information to come up with some thoughts on valuation.

Technical Analysis dominates in this environment. It's the only thing that an investor can rely on. Buy and Hold is dead and over until further notice.

The unrelenting rout in stocks is adding further pressure on battered pension funds. Global Pensions reports that the latest Wilshire Associates data reveals that US state and public pension funds ended 2008 with an aggregate deficit of US$237bn:

The consultant surveyed 125 US public defined benefit (DB) funds – of which 59 had reported actuarial values on or after 30 June 2008 – and found the aggregate market value deficit had widened to $237bn from $155.3bn in 2007.

Wilshire said the actual coverage ratio of plans which had reported on this basis was 77%, down from 94% last year – while the estimated coverage ratio for all plans was 84%, a decline from 96% in 2007.

On an actuarial basis, plans which had reported their funding status faced an aggregated deficit of $202.3bn, an improvement from the $362.7bn deficit in 2007, while the reported and estimated funding ratios were 81% and 86% respectively.

The consultant said solvent plans and under-funded schemes together could “mask the underlying fiscal strength or weakness of individual plans”, due to the non-transferability of assets.

It said 55 of the 59 schemes which had produced data were under-funded. In isolation, their aggregate shortfall increased to $240.5bn, or a funding ratio of 73%.

In contrast, the four schemes which had greater assets than liabilities had a funding excess of $3.5bn and a funding ratio of 103%.

In terms of asset allocations, public plans predominantly invested in equities, with US and international shares comprising 56.9% of assets. Since 2003, Wilshire noted, the proportion of US equities held had decreased slightly, from 42.3% to 38.1%, while international equities had increased to 18.8% from 12.9%. Similarly, overall bond holdings fell, from 36.6% in 2003 to 31.6% in 2008, with US bonds falling from 35.2% to 26.7% and non-US bonds falling a half percentage to 0.9%. Some of the reduced debt holdings were offset by an average 4% allocation to ‘other’ debt instruments over the period.

The combined deficit of the largest 200 companies hit a high of 73 billion pounds as the FTSE slumped to its lowest level in six years. On February 26 the aggregate deficit was at 38 billion pounds, and by Wednesday it had come back to 56 billion.

The sharp movements have come as pension funds prepare to calculate formal pension deficit levels at end-March. Trustees will use that figure to inform requests for contributions from their corporate sponsors and further sharp drops could trigger large demands for money from cash-strapped employers.

"The past week has been the most volatile for final salary pension schemes since accounting standards were changed in June 2001," said Marcus Hurd, head of corporate solutions at Aon Consulting.

The consulting firm said Monday saw the biggest single day loss on record of 27 billion pounds, dwarfing the previous biggest loss of 16 billion on Oct 15, 2008."

On Tuesday, the FTSE 100 index hit a six-year low as worries about the outlook of the financial sector and the broader economy resulted in leading investors dumping stocks.

Pension funds are major investors in equity markets and extreme volatility has a knock-on impact on their funding levels. The AA corporate bond yields used to help calculate pension liabilities have also been erratic, Aon said.

"We are seeing swings of unprecedented proportions at the current time. With one half of companies about to formally report their position at 31 March, this is a real concern," Hurd said.

He added: "Company directors are facing a roulette wheel of pension scheme deficits and hoping that markets are at a high when the ball stops rolling. The levels of changes we are seeing are frightening even the hardiest finance director."

By now, it's painfully obvious that most pension funds are overexposed to public equities. Many of them are also overexposed to alternative investments like hedge funds, private equity and commercial real estate.

Hedge fund assets fell 33 per cent to $1.81 trillion (U.S.) at the end of 2008, from a peak of $2.70-billion at the end of June, according to research on 6,000 fund managers compiled by HedgeFund Intelligence, a leading commentator on the industry.

“The decline in assets under management flows from a mixture of negative performance and net redemptions from the industry,” said HedgeFund Intelligence. The group predicted a further 20 per cent decline in assets this year, as investors continue to pull money from funds that only allow a certain percentage of holdings to be redeemed at any one time.

The average return from funds that this survey measured was a 15 per cent loss in 2008, but as HedgeFund Intelligence pointed out, there was an enormous range of returns last year, including a significant minority of managers who actually made money.

“Despite what was undoubtedly a very difficult year, the overall performance from hedge funds in 2008 was still much better than in equity markets and most other asset classes, and there were many individual funds that delivered excellent (and positive) risk-adjusted returns,” said Neil Wilson, editorial director of HedgeFund Intelligence.

“And despite some further redemptions already in the pipeline, with the outlook for global markets still looking uncertain it seems to us that investors will increasingly conclude that many hedge funds will offer better ways to invest money and manage risk than the other alternatives.”

The survey found more than 450 funds shut down worldwide. There are still new funds opening, but the pace has slowed. In the U.S. there were 55 funds launched last year with $50-million or more, There were 81 funds of that sized started in 2007.

Membership in the billion dollar club fell from 395 fund managers in mid-2008 to only 311 funds with assets of $1-billion or more. The combined assets of this group also fell sharply, from $2.16 trillion to $1.46 trillion.

New York remains the top centre for hedge funds with over 120 ‘Billion Dollar Club' firms and 47-per-cent of the assets of the big money managers. London, in second place, has 65 $1-billion firms with 17 per cent market share of assets.

Institutions such as pension funds and university endowments now account for more than half of the $1.4 trillion (992 billion pounds) hedge fund industry's assets, surpassing wealthy individuals, trade body AIMA said on Wednesday.

The Alternative Investment Management Association (AIMA), which represents the global hedge fund industry, said it estimated that this had risen from one-third three years ago.

Pension funds by themselves now account for one-sixth of overall hedge fund assets, it added.

Whilst high net worth individuals have traditionally been the main backers of hedge funds, investors such as pensions, endowments, foundations and governmental authorities, which invest for the long-term, have slowly been raising exposure to the freewheeling asset class in the hope of positive returns in all markets.

Record losses from hedge funds in 2008 saw investors pull out cash rapidly, with $152 billion leaving in the fourth quarter, according to Hedge Fund Research, taking total assets to $1.4 trillion at the end of the year.

However, anecdotal evidence suggests that at least some institutions have been adding.

This week the Universities Superannuation Scheme, Britain's second-largest pension fund, said it was sticking with a medium-term plan to double exposure to alternative assets such as hedge funds and private equity.

AIMA, said the research was based on extensive consultation with its members.

"These figures demonstrate that the hedge fund industry plays an extremely important role globally for the institutions that look after everyone's pensions and savings," said AIMA Chief Executive.

The irony is that pension funds are investing billions in hedge funds that are net short large cap stocks. Many hedge funds are now shorting the asset allocation of pension funds that are overexposed to stocks - and they are collecting 2 & 20 for this "alpha"!

U.S. private equity firms are reporting substantial write-downs on their portfolios for the year, but investors are already anticipating the next round of cuts if the equity markets continue to fall.

Blackstone's private equity funds were written down 31 percent for the year and 20 percent for the quarter, according to a person who saw a letter the firm sent to investors.

KKR Private Equity Investors, listed in Amsterdam, said this week that its net asset value, which tracks the worth of its investment portfolio, had been cut in half by the end of December from a year ago and had dropped 32 percent from the third quarter.

For the fourth quarter, Carlyle Group wrote down its buyout fund, Carlyle Partners IV, by 13.8 percent, a person who had seen the data said. The material was confidential and the person was not authorized to disclose the information.

In Europe, some write-downs have been dramatically worse. The British firm Terra Firma, whose biggest investment is the music company EMI, reported a 42 percent reduction in the fair value of its investments, according to its Web site.

One investor estimated that the industry average will be down 30 to 35 percent for 2008 compared with December 2007.

Private equity firms like Blackstone that are themselves publicly traded and buyout firms that have funds that are listed report their figures to the market.

The numbers vary widely among firms and can be hard to compare, as buyout firms use different methods to value assets.

But investors and analysts say that unless the equity markets recover, more write-downs are expected for the three months ending in March. The Standard & Poor's 500 Index is down 21 percent so far this year.

"I'd expect more markdowns" if current conditions hold - "absolutely," said Neil Beaton, national partner in charge of valuation services at the accounting firm Grant Thornton.

Steven Kaplan, a professor of finance specializing in private equity at the University of Chicago, said the values of the assets reported for the year were almost "certainly too high" given where the equity market is now.

Many buyout firms argue that the cuts do not reflect the long-term value of the companies they own or the prices they expect to receive when they sell the assets. Blackstone told investors on a call Tuesday that if the accounting standards had been applied to one of Blackstone's older buyout funds during a similar market trough, the portfolio would have been valued at just three-tenths the cost of the investments, according to a person who heard the call.

But when the investments were sold, the value realized for investors was actually more than double the cost, it said.

Henry Kravis, co-founder of Kohlberg Kravis Roberts, said Monday that while KKR Private Equity Investors, also known as KPE, had cut the value of a number of its companies, many had in fact improved profits.

Private equity firms are obliged for the first time this year to value their companies as if they were to sell them today, rather than years in the future when they might be sold. The accounting rule known as FAS 157 took effect for financial years beginning after Nov. 15, 2007. Previously, firms held the assets on their books at the original cost for the years until they sold them.

One problem investors identify is the varying methods firms are using to mark their assets. Investors say that has resulted in some cases in one asset's being marked at different prices on two private equity firms' books. That occurs when two or more buyout firms have joined together to buy a company.

"Everyone does it differently, and that's the problem," Beaton said.

There are two methods that buyout firms use to value their portfolio companies. One is to look at how comparable publicly traded firms are performing. The second is to predict the asset's future cash flow, known as discounted cash flow, or DCF.

Most companies prefer using the market method but are deferring to the DCF model right now because the markets are so volatile, Beaton said.

Firms can also use both methods and weight them to come up with one number that is, for example, 70 percent based on DCF and 30 percent based on public multiples. "Every time you enter into a subjective situation like fair value, you are going to get differences," Beaton said. "Is it more transparent than the traditional cost approach it replaced? Yes. At least it attempts with some structure to provide what the company and the auditors believe are the fair values for those companies."

Kaplan said the increased disclosure was good for investors but had downsides, too.

"The negative of mark-to-market is that it may exacerbate the boom-and-bust cycle that you see in private equity - that when returns go up, money flows in, and when returns go down, money doesn't come in," he said.

The weakest alternative investment right now is commercial real estate. Atlanta Federal Reserve Board President Dennis Lockhart said he is 'increasingly paying attention' to the commercial real estate market as a sector that could pose problems for banks trying to recover from rising defaults and bankruptcies, and might even delay overall US recovery.

As the residential real estate market continues its downward trajectory, the ripple effects of the crisis threaten the $8 trillion commercial real estate market. Offices, stores and industrial buildings are all facing a perfect storm of increasing vacancies and a lack of capital with which to refinance their debt.

“Really since the start of the year the trouble is coming out of the woodwork as far as notices of default, foreclosures, bankruptcies,” said Bob White, founder and president of Real Capital Analytics, a real estate market research firm. “It’s growing alarmingly fast.” Currently, some $50 billion worth of commercial mortgages are in default or foreclosure. White and others in the industry say the worst is yet to come.

“The two key things creating problems are the tenants are having financial difficulties, especially retail tenants, and there’s a dearth of capital out there for even healthy properties to refinance debt,” said Steven Ott, director of the Center for Real Estate at the University of North Carolina, Charlotte.

Like the residential real estate market, commercial real estate loans were bundled into securities. “The commercial mortgage backed securities market and further derivatives built on that have a very similar structure to the asset backed market the residential mortgages were pooled into,” said David Geltner, director of research at the Center for Real Estate at the Massachusetts Institute of Technology. “You have subordination levels governed by credit rating agencies. Obviously in retrospect, those subordination levels were way too low.”

It’s helpful to think of securitization as an accelerant: It lets returns zoom up during a boom, but it magnifies and spreads the pain of losses in a crash. Now, even stable businesses face guilt by association when they try to refinance: skittish over rising default rates, lenders are tightening up the purse strings for everyone. “Even well-capitalized insurance companies or commercial banks don’t want to catch the proverbial falling knife,” said Victor Calanog, director of research for commercial real estate analysis firm Reis. “Values may still fall.”

Unlike the residential sector, however, experts say that lending practices — at least until the height of the boom — remained conservative in the commercial market. A bruising slump caused by overbuilding that created a glut of unfilled supply in the early 90s was still fresh in the minds of many developers and commercial lenders. By contrast, until last year, the United States had never experienced an across-the-board drop in home prices, making it almost believable that values would never weather a sustained, nationwide decrease.

By 2006 and 2007, though, the commercial market succumbed to bubble thinking. Prices increased and lenders began relying only on recent performance when rating the credit-worthiness of commercial mortgages. “The underwriters for these securitized loans were basically very optimistic about the ability of commercial properties to increase their income,” says Reis’s Calanog. In other words, the maxim of ‘what goes up must come down’ went out the window. Analysts are quick to point out that if commercial real estate lenders hadn’t been as disciplined as they were, the problems the market faces would be even worse than they are now.

The problem runs deeper than bubble economics, though. Thomas Bisacquino, president of the National Association of Industrial and Office Properties, says that most of the industry’s coming crisis isn’t due to irresponsible lending, but rather to the way commercial loans are structured. Unlike home mortgages, which are usually for a few hundred thousand dollars and repaid over a 30-year term, banks lend businesses up to tens of millions in shorter-term increments, usually five to seven years.

Unfortunately for millions of commercial-property mortgage holders, their terms ending just as the credit market grinds to a near-complete halt. This lockdown of the credit markets means that loans can’t be refinanced, pushing even healthy businesses onto the foreclosure tracks.

MIT’s Geltner estimated that bubble pricing was responsible for an approximately 15 percent run-up in prices, which would have impacted only the most aggressive borrowers when they fell. Instead, he estimates that the commercial sector overall has dropped by 15 to 20 percent already, and will probably drop by that much again before turning around.

Other industry experts agree. The problem is going to get worse before it gets better. “We’re projecting 17.6 percent vacancy for the office sector through the end of 2010, which is the highest level since 1992,” said Calanog. “The last time we saw this was during the savings and loan crisis.” Rising unemployment numbers illustrate another facet of the problem; when companies cut people, their need for space decreases, as well.

Offices aren’t even the hardest-hit of the sector. Retail space is suffering greatly as businesses ranging from mom-and-pop operations to major department store chains fold. “The sector we are most pessimistic about is the retail sector,” said Calanog. “In 2008 we were quite alarmed when we saw a significant decrease in performance, a decline in occupied stock we’d never seen in this sector before.” Since consumer spending has contracted for the first time in decades, retail owners face a grim outlook in the near term.

Just as commercial real estate’s fall has lagged behind the fate of the residential market, a turnaround won’t take place until well after the home foreclosure crisis has been contained. Right now, most of the government’s energies are focused on keeping people in their homes, which means fewer dollars and resources are being funneled into the commercial sector.

While the commercial market will receive some of the money the government has set aside to buy various types of loans via the Term Asset-Backed Securities Loan Facility (aka TALF) program, the bulk of TALF funds are going towards freeing up the consumer lending categories of home loans, car loans and credit-card debt. There’s also no equivalent of government-backed mortgage agencies Fannie Mae and Freddie Mac to which most commercial property owners have access.

“We need the government to step in and provide guarantees for the commercial mortgage-backed securities market,” said NAIOP’s Bisacquino. “There is a lot of private equity sitting on the sidelines. TALF can provide the guarantees to get that to return.”

Industry advocacy group the Real Estate Roundtable has a five-point proposal for turning around the commercial real estate market. It lobbies not only for TALF funding but for greater leeway for loan servicers, allowing them to modify loan terms. The plan also calls for changes to accounting and tax rules and encourages foreign investment in the commercial mortgage-backed securities market.

In the future, many want to the government to introduce legislation that requires accountability. “I think part of the long-term solution to this is people have to have skin in the game,” said MIT’s Geltner. “If you get a bonus it has to be based on long run performance.”

And this concludes my brief tour of pensions' alternatives albatross. Tomorrow we'll get another dismal jobs report and we'll see how markets react. Just remember, it's your pensions that are fueling the speculators taking positions in that casino we call the stock market.

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This blog was created to share my unique insights on pensions and investments. The success of the blog is due to the high volume of readers and excellent insights shared by senior pension fund managers and other experts. Institutional and retail investors are kindly requested to support my efforts by donating or subscribing via PayPal below. To get latest updates, even during the day, click on the image of the big piggy bank at the top of the blog. For all inquiries, please contact me at LKolivakis@gmail.com.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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